Monday, September 8, 2008

When your Secretary of the Treasury has to reassure foreign central banks that their holdings in Freddie Mac and Fannie Mae are sound, everyone should be concerned, particularly U.S. taxpayers. The “soundness” does not come from confidence in the underlying assets that have now significantly eroded, but in the reassurance and commitment that the U.S. taxpayers will stand behind those securities or loans. By agreement, the Treasury will be required to maintain positive net worth for both institutions.U.S. taxpayers are now on the hook for exceedingly bad decisions made by lending institutions, brokers and borrowers. Dependence on foreign lenders such Japan’s and China’s central banks has enabled the funding of everything from second mortgages for the acquisition of the latest surround-sound 56 inch plasma screen TVs, to the bankrupting war in Iraq. While this move by Treasury may be receive positive responses from Asia, the size of the underlying problem is not known. For now everyone but U.S. taxpayers will sigh with some relief.

Neither the White House nor Congress (either Republican or Democrat led) had the good sense to implement effective regulation or oversight of financial institutions and markets. The U.S. dollar’s status and its prominence as the defacto international currency made the borrowing easier, and when you add the fact that many products consumed were made by the very willing creditor countries, we now have a debt balloon the world was unprepared for. Regardless the outcome for American taxpayers, the correction that may last a few years while the impact unravels, will inevitably change the global economic system, and impact all North American lifestyles, if not standards of living.

Freddie and Fannie were two major players that were managed by free-wheeling individuals whose agendas were dictated by egocentric priorities, and NOT by Doing The Right Thing Right. Unfortunately they are only two in a long list of institutions, including banks throughout the nation, whose executives should have been less self-serving, and who should have demonstrated more common sense. The Freddie and Fannie take over by the Treasury should ring alarm bells, and although it provides the appearance that things are under control, the announcements make no mention of the ominous possibilities that may await the Federal Deposit Insurance Corporation (FDIC). The supposed final bastion of deposit protection in the event of bank failures is only capable of covering sporadic failures, not a wholesale cave-in of the system.

Oversight and control of the past is impossible, and although measures must be implemented to prevent recurrence of the excess evidenced in the past decade, Congress should implement dramatic measures to reduce Federal spending. It should probably start with the military’s annual consumption of trillions of taxpayer dollars. Consumers and taxpayers have already begun their own reduction in spending, now the Federal and State governments must follow suit. Both candidates running for the Oval Office should make the economy the priority, and we should be hearing more of their plans for solutions to the current financial crisis.

1 comment:

Though few may have noticed, the past few weeks may be regarded as a global economic turning point. Evidence is mounting that the United States is entering a recession, with increasing signs that it could morph into a depression. While the current Administration appears resigned to bail out or nationalize large tracts of American commerce, the presidential candidates drift towards Great Society era spending proposals. At the same time, America’s principal economic rivals appear to be charting courses that are not in line with U.S. interests.

The Russian invasion of Georgia has revived tensions that have not been seen since the most frigid periods of the Cold War. With the Olympic Games over, China can relax and now exert its muscle without risking any politically motivated boycotts. Between them, these global players hold well over a trillion dollars, or 10 % of U.S. government debt, which they can use in as leverage in any strategic, economic or political confrontation with the U.S. There is also evidence that America’s economic power is even waning in our own back yard. This week, Honduras, a traditional U.S. ally in Central America, announced that it was throwing its lot in with a Latin American trade bloc dominated by Venezuela and Cuba!

For two years I have warned readers of a severe, real estate led recession and encouraged extreme asset allocations to cash, particularly short-term, hard currency government bonds, and gold. Last year, I urged short positions in financials and U.S. stock markets. Some ridiculed me. The financials are currently down some 84 percent. Apparently, the real estate crash is biting deeper than just about any market “expert” had imagined.

The size of the problem is enormous. A fall of just 20 percent in U.S. house values, (which is confirmed by the latest Case Shiller data release) wipes almost $5 trillion from the wealth of American consumers and businesses. This amounts to more than one third of America’s GDP and half of the total U.S. Government debt! How could the fallout be anything less than systemic?

Imprudent lending behavior, inspired by the housing boom, placed the security of banks depositors and shareholders at undisclosed and unprecedented risk. The banking problem is so large that failures cannot be allowed. The government has bent rules regarding financial reporting and the Fed’s lending criteria to keep the financial ship afloat.

The main focus for now is on government sponsored lenders Fannie Mae and Freddie Mac, who are now understood to be hopelessly undercapitalized. Despite the complete predictability of this outcome, even conservative investors, including many banks, had been persuaded that securities issued by both Fanny Mae and Freddie Mac were risk free. And although shareholders for both entities are likely to be wiped out, corporate bond holders, and those individuals and financial institutions who hold mortgages backed by both the GSE’s, correctly assume that the government will back their assets. However, hundreds of billions, perhaps trillions, of Federal dollars will be needed to make whole all who foolishly loaded up on Fannie and Freddie debt. Unfortunately, the Federal cupboards are bare.

This week, the Federal Deposit Incurrence Corporation (FDIC) announced that its problem list had increased from 90 banks to 117. Worse still, the FDIC announced its fund had fallen below its legal deposit ratio, forcing it to increase its levy on member banks. This, just when the net income of its member banks, in desperate need of retained earnings, has fallen by some 86 percent. As more banks begin to fail, the ultimate cost to the Federal balance sheet is hard to imagine.

But, as the old saying goes, ‘What’s good for the goose is good for the gander.’ So, if government financial ‘favors’ are granted to reckless investment firms (Bear Stearns) and now mortgage borrowers, what about other economically vital ‘multiplier’ industries like: automakers, airlines, credit card and insurance companies and even corporate real estate lenders? The logical conclusion for this current drift is hyperinflation. In order to make good on its promises the Federal Government will have to resort to the printing press…with a vengeance.

With America facing severe recession, many regions around the world will suffer. So who will suffer least? Nations that have run relatively prudent economic policies and those who ‘produce’ goods required even in an economically depressed world will continue to prosper increasingly, relative to the U.S.

The differential may become magnified as America’s government hyper-inflates. Investors will then increasingly dump dollar paper assets and buy hard currencies, government bonds of ‘producer’ nations and gold. Investors ahead of this depression curve will likely suffer least!

For a more in depth analysis of our financial problems and the inherent dangers they pose for the U.S. economy and U.S. dollar denominated investments, read Peter Schiff's book “Crash Proof: How to Profit from the Coming Economic Collapse.”